A I

Policy, Research, and External Affairs

WORKING PAPERS

Agricultural Policies

Agriculture and Rural DevelopmentDepartment

The World BankMay 1991WPS 670

Inflation Adjustmentsof Financial Statements

Application of InternationalAccounting Standard 29

Yaaqov Goldschmidtand

Jacob Yaron

A framework for applying International Accountinig Standard29 to adjust the financial statements of revenue-earninlg enter-

prises operating in inflationary economies.

ThePolicy,Rescarch, and External Affairs Complex distributcs PRI' Working Papers to dissemnuatc the findings of work int progress and

to encouragc the exchange of ideas among l3ank staff and all others interested in development issucs. These papers carfy the names of

the authors, rnilct only their views, and should be used and cited accordingly. bhe findings, interpretations, and conclusionls are the

authors' own. they should not be atuibuted to the World Bank, its 13oard of Directors, its maanagerctnt, or any of Its member countnes.

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Poicy, Research, and Exlernsl Affairst

Agriculitural Policies

WPS 670

This paper - a product of the Agricultural Policies Division, Agriculture and Rural DevelopmncntDepartment - is part of a larger effort in PRE to provide guidance on the design of financial institutionsand on their management practices. Copies are available free from the World Bank, 1818 H Street NW,Washington, DC 20433. Please contact Cicely Spooner, room N8-035, extension 30464 (54 pages).

The Bank's draft Operational Directive on IAS 29 provides a list of principles andFinancial Sector Operations requires the adjust- requirements but does not outline the procedurement of financial statements in countries where for measuring income. Nor does it provide athe rumulp-ve inflation rate over three years numerical example.approache, or exceeds 100 percent. Financialstatements in those countries are to follow the This paper provides a framework for apply-accounting principles in International Account- ing IAS 29 to adjust financial statements accomii-ing Standard 29 (IAS 29) of the International panied by numerical examples and thus may beAccounting Standards Committee. considered as an extension of the standard.

The PRE Working Plaper Series disseminates the findings of work under way in the Bank's Policy, Research, and ExternalAffairsComplex. Anobjective ofthc series is to getthescfindings outquickly, even ifpresentations arc less than fully ilk)ishC(.The findings, interpretations, and conclusions in these papers do not necessarily reprcsenl official Bank policy.

Produced by the PRE Dissemination Ccnter

INFLATION ADJUSTMENTS OF FINANCIAL STATEMENTS

(Applicatioza of International Accounting Standard 29:

Financial Reportinq in Hyperinflationary Economies)

CONTENTS

Foreword1. Introduction

1.1 Distortive effects of inflation1.2 Inflation adjustment according to IAS 291.3 Advantages of IAS 291.4 objectives of the paper1.5 The role of balance sheet in income measurement1.6 Classification of balance sheet items1.7 Inflation-adjustment by an outside analyst1.8 Working steps

2. The unique behavior of interest expense during inflation2.1 Determiring the nominal interest rate2.2 Effect of inflation on loan repayment2.3 Illustration2.4 Gain or net monetary position2.5 Deriving the real interest rate2.6 A case of suppressed interest rate

3. Illustration of adjusting financial statements3.1 The original data3.2 Restating the opening balance sheet3.3 Restating intra-year capital transactions3.4 Restating the closing balance sheet3.5 Deriving the year's adjusted net income3.6 Adjusting the income statement3.7 Restating all income statement items3.8 Updating time-series restated figures

4. Tools for restating financial data4.1 Restatement factor4.2 Restating historical figures4.3 Updating restated figures4.4 Average price index4.5 Restating intra-year flows4.6 Holding time of inventories4.7 Restating inventories4.8 Restating marketable securities4.9 Restating depreciable assets4.10 Restating special assets

I ;ianclal statements without adequate adjustment to LnflatLon do not

reflect appropriately the flnanclal pooltion and performan e of buslness

enterprises. Purthermore, unadjusted financLal statements can be meaningless

or even misleading under Lnflationary condLtions. Several countries have

implemented dlfferent adjustment procedures resulting in lack of uniformity.

A uniform solutLon to the problem of assessLng fLnancial performance of

eraterprLses ln an inflationary environment has been long overdue.

Recent developments, however, have resolved much of the above problems.

These developements are:

a) A new Internatlonal Accountlng Standard (IAS 29) was issued

in July 1989, settlng up the framework for meaningful and uniform

fLnancLal reporting in LnflatLonary economies. Thls International

Standard specifles the adjustment requirements and has become

operative for flnanclal statements covering periods beginning on or

after January 1, 1990.

b) The Bank draft Operational D&rective (OD) on financial sector

operatLons cequires Bank borrowers in countrles where the cumulative

inflatlon rate over three years ls approaching or exceeds 100% to

adjust their flnancial statements in accordance with IAS 29.1

1 The Bank OD requires that flnancial statements be based on the inflation

accounting principles laid down ln Internatlonal Accounting Standard 29 (AnnexA, para 4(d). Furthermore, the OD calls for financial and loan collectionperformance that ..."takLng inflation into account, avoids the erosion of itscapital" (OD, page 17 para 65 (c)). In our opinion, the measurement of capitalpreservation can be achieved, under inflationary conditions, only throughcarrylng out the adjustment of financial statements to inflation.

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It is worth mention£ng that the standard Bank loan agreement with a

borrower other than memaer country requires thatt "the borrower shall maintain

zecords and accounts adequate to reflect, in accordance with sound accounting

practice, its operations and financial condition"2. With the issuance of IAS

29 therefore, compliance with this standard by Bank borrowers which are revenue

earning entities, should be required persuant to the borrower's basic obligation

to maintain "sound accounting practice".

The aims of this paper are (i) to inform Bank staff, borrowers, their

CEO's, chief accountants, those who are directly responsible for financial

reporting and their independent external auditors on the need to comply with the

financial reporting requirements set by IAS 29, for all financial statements

scheduled to be submitted to the Bank, covering pariods beginning on or after

January 1, 1990; and (ii) to provide explanations on the framework, and to

suggest procedures to carry out the adjustment.

IAS 29 provides a list of principles and requirements. It does not,

however, delineate the procedures for measuring the adjustec income nor does it

provide numerical illustrations. The present paper may be considered as an

extension of the Standard as it provides a framework for applying IAS 29 for

adjusting financial statements, accompanied by numerical examples.

2 Article V section 5.01 of the typical loan agreement with such entities.

Also, the standard Bank loan agreement entitles the Bank to requires the borrower

to furnish to the Bank reports of audits of its financial statements carried out

in accordance with appropriate auditing principles consistently applied of such

scope and in such detail as the Bank shall have reasonably requested..." Ibid.,

Article V, Section 5.01 (b).

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The applicatiotn of IAS 29 to a financial institution iE qimpler than that

of an industrial or an agricultural enterprise. This is betcause the former does

not carry matcerial inventories of goods which should be restated during

inflation and the a .ire of depreciation in total expenses is relatively low.

Therefore, the paper illustrates a full application of IAS 29 to an agro-

industrib,l enterprise.

Xt is beyond the scope of this paper (i) to estimate the resources, both

human and financial that would be required to accomplish the task of adjusting

financial statements and (ii) to delineate short-cut procedures which can ease

the task of applying IAS 29, especially when carried out by an outside analyst.

However, it is safe to claim that the resources needed for accomplishing

the required adjustment are significant, and that without Bank initiative, at

this stage, many borrowers would be either uninfornied of or incapable of

complying with the adjustment requirements laid out in the IAS 29.

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1. Introduction

The International Accounting Standards Committee issued in July 1989, the

International Accoun>ing Standard (IAS 29) - "Financial Reporting in

iyperinflationary Economies", which became operative for financial statements

covering periods beginning on or after January 1, 1990. "This statement applies

to the ... financial statements ... of any enterprise that reports in the

currency of a hyperinflationary economy" (par. 1). Hyperinflat'or t.s indicated

by several characteristics of the economic environment of a country, ... [mainly

where) the cumulp'^ive inflation rate over three years is approaching, or

exceeds, 100% - that is, 26% per annum (par. 3).1 Several countries have

already adopted requirements that conform with IAS 29.2 This standard will

certainly improve "the quality of presertation of financial statements" and

"increase the degree of uniformity", as stated in the Preface to IAS.

1.1 Distortionary Effects of Inflation

conventional financial statements of a company are based on the as! impt ion

that the monetary unit is stable. 'Under inflationary conditions, however, the

purchasing power of the money declines, caising some crucial figures of the

conventional financial statements, especially net income and nonmonetary assets'

value to be distorted. Thus, "a ..undred feet plus ten centimeters is certainly

not a hundred and ten anything, and the accountantfs balance-sheet total is not

much better". (Boulding, p. 54).3

In other words, during a period of inflation, the values of assets and

ome cost items (such as depreciation of fixed assets), as recorded in the

financial statements, tend to be understated. To provide meaningful

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information, these figures should be revalued. heveluation ctan be carried out

j,n several ways, mainly by adjusting the acquisition cost of each unlt of fixed

asset or batch of r&ue material by the appropriate price index or market price.

These ways are, however, tedious and costly. Short-cut procedures can provide

approximate revalued fiTures, thereby ove;' oming the main distortions which are

eminent in conventional financial states ints of companies reporting in an

inflationary economy.

1.2 Inflation Adjustment According to IAS 29

Inflation adjustment is carried out, according to IAS 29, by restating

some relevant figures using the general price index that reflects changes in the

general purchasing power. The adjustment does not deal with 1) changes in

relative value of assets and goods as measured by specific price indexes, or 2)

the replacement value of assets and goods, as some standards dealing with

inflation-adjustments ot financial statement.4 However, to follow the

accounting principle of "the lower of cost or market value", market values

should be obtained. In summary, IAS 29 requirements are an extension of the

historical-cost accounting methods, where adjustments are made for changes in

the general purchasing power of the money re measured by the consumer price

index.

1.3 Advantages of IAS 29

IAS 29 provides relatively few requirements for adjusting financial

otatements of a company reporting in a "hyperinflation economy". The figures

in the resulting adjusted statements should convey the same meaning as those

derived from conventional financial statements when stable prices prevail.

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lAS 29 has an important advantage over other standards dealing with

inflation-adjustments of financial statements: It places high importance on

arriving at usable information ratier than stressing detailed recording and

computati-nal procedures, as can be learned from the following.

"The restatemnent of financial statements in accordance with thisStatement requires the application of certain procedures as well as

judgement. The consistent application of these procedures and

judgments from period to period is more important than the preciseacouracy of the resulting amounts included in the restated financial

statciiients." (IAS 29, par, 8; emphasis added).

Furthermore, IAS 29 suggests use of an independent professional assessment in

cases where detailed records of acquisition datos are not available (par. 14).

As such, IAS 29 should be classified within Dewhirst's two bigner level

accounting theory models, as described in a recent paper in the International

Journal of Accounting.5 These two higher level models are:

1) The Substance Oriented Model, which "emphasizes both e-e

balance sheet and income statement to represent the economic

situation of the accounting entity", and

2) The Needs Oriented Model, which emphasizes "user decision-

making information satisfaction", (p. 107), rather than a Procedure

Oriented Model, which accounts for processing transactions under

generally accepted accounting principles.

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1.4 objectiveo of the Pa

The paper follows the spirit of lAS 29 in emphasizlng the usefu3n"ss of

the inflatLon-adjusted flnancial data, by applying procedures and judgment

coneietently rather than stressing preclison and accuracy. (IAS 29, pare 8).

The objectLve of thLs paper is to outllne the procedures to b.s used in

applying IAS 29 to restate a company's conventional financial statements and to

illustrate these procedures. The maln procedures are related to the restatement

of balance sheet items.

There are two approaches for restatlng balance-sheet items:

1) A comprehensive procedure where each transaction related to both

balance-sheet and income-statement items is restated. This

procedure suits the case where all the data required for restating

purposes are available and relLable.

2) Simple procedures where only key balance-sheet items are restated.

These procedures suit the case where either the required data are

not available or where full in-depth analysis is not called for.

The latter is especlally suitable for adjusting published financial

statements by an outside analyst as explained in Section 1.7.

This paper provides the framework for applying both approaches for

restating the financial statements. It also presents some procedures

accompanied by numerical ill stratLons that can be classified within the second

approach. However, presentlng short-cut procedures that will enable an outside

analyst to carry out a complete adjustment of a company's financial statements

is beyond the scope of this paper.

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A major effect of inflatlon on the financial statements is through the

unique behavLor of the interoet expense. Thsrefore, this subject is presented

as an extended introduction (Chapter 2).

1.5 The Role of Balance Sheet in Income Meaourement

Inflation-adjusted net income of a company in a period is beat determined

by the change in its equity (excluding new issues and distributions), measured

in constant prices, between tho closing and openlng balance sheets.6 The value

of equity is equal to the value of "ssets at curren prices less liabilities,

stated at the price level of the balance sheet d 'e. The net income after tax

and after dividends is eetained (that is, added to the reb.rve or equity account

with the balance sheet); thus, it is stated in terms of the price level at the

closirng balance sheet date. Under IAS 29, the inflation-adjusted (current-cost)

net income is determined by adding to or subtracting from the historical-cost

net income some inflation adjustments of costs and values that are related to

balance sheet items. IAS 29 also requires restating the income-statement items.

1.6 Classification of Balance Sheet Items

Balance sheet items are classified into two distinct types -- monetary and

nonmonetary items.

Monetary Items - Monetary items are assets and liabilities, the nominal value

of which is stated in monetary units which represents the real value of the item

concerned regardless of changes in the general price level, such as cash,

accounts and notes receivable or payable in domestic currency, and loans in

domestic currency that are not linked to a price index or pegged to another

currency. These itema are expressed in current prices. Loans linked to a price

9

index or pegged to another currency are recorded ln the conventional financial

statement at restated value; thus, theme loans are already recorded in current

prices. Holding monetary assets, the return of which is not infl&tLon-

compensated (e.g. cash), results, under inflationary cond'tions, in loss of

purchasiag power-

Nonmonetary Assets - Nonmonetary assets are assets the nominal value of which

changes with the general price level, such as fixed assets, sharea nd

inventories. These assets must be restated in current costt that is, the assewJ

will continue to be recorded at cost, but cost in terms of current purchasing

power at the date of the balance sheet.

In summary, monetary items (cash, receivables, payables, loans) should not

be restated; nonmon.etary assets (Lnventories, shares, fixed assets), on the

other hand, must be restated.

1.7 Inflation-Adjustment by An Outside Analyst

The main work involved in inflation-adjustment of financial statemerts is

the restatsment of nonmonetary assets. For this purpose, detailed data on the

acquisition coots and rates of a -Large aiount of items are required. I., some

cases, these data are not available, especially to an outside analyst. In other

cases, these data are not reliable or the costs of collecting and processing

these voluminous data become prohibitive.

To overcome these limitations, simplified and approximating procedures can

serve as a second best method. These procedures are applied to the stock of

each category of nonmonetary assets. Thus, restatement can be carried out by

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applying the approximating procedures to only those ltems for which detailed or

reliable data are not available.

1.8 Working Steps

There are seven steps in inflation-adjustment of a company's financial

statements. The first four steps provide restated balance sheets and adjusted

net income for a given year. The next two steps provide an adjusted income

statement and the last step provides meaningful financial figures for time-series

analysis.

1. Restating the opening balance sheet for the year under analysis.

This is the main time-consuming step, especially regarding the fixed

assets.

2. Restating intra-year capital transactions.

3. Restating the closing balance sheet, to arrive at current values.

4. Deriving the year's adjusted net income.

5. Reistating depreciation and stocks of inventories to arrive at the

adjusted income statement.

6. Restating all income-statement items (that is, outputs and inputs)

to arrive at year-end values.

7. Updating time-series restated financial figures to the last year's

prices, to enable inter-year comparisons of financial information.

The application of these steps to a simplified set of financial

statements is presented in Chapter 3.

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2. THB UNIQUE BEHAVIOR OF INTEREST EXPENSE DURING INFLATION

Inflation has essentially two major effects on the figures reported in the

financial statements of a company:

1. The recorded acquisition (historical) costs of nonmonetary assets

are understated in terms of current prices (assets value, materials

from inventory and depreciation expenses).

2. The interest expenses include inflation-compensation of the

principal; that is, a fracrtion of the recorded nominal interest

expense, is, in an economic sense, a balance-sheet item rather than

an income-statement item.

This unique behavior of interest expense during inflation causes

conceptual complications in adjusting conventional financial statements, as

e%plained in this chapter. This aspect has also serious effects on the

financial liquidity of the firm, a subject not presented here because it is out

of the scope of this paper.

2.1 Determining the Nominal Interest Rate

Inflation affects nominal market rates of interest. Assuming that the

long-run, pre-inflation interest rate remains unchanged during inflca_con, then,

during inflation, the nominal interest rate when inflation is fully anticipated,

includes both the pre-inflation, real interest rate and the inflation rate.

Accordingly, the nominal interest rate is determined as follows

r = (1 + r*)(l + p) - 1 - p + r* (1 + p)

where r - required nominal interest rate - inflation-compensated rate,

r* long-run, pre-inflation interest rate,

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p - inflation rate, expected.

Suppose the pre-inflation interest rate is 5% and the expected inflation rate

is 20%, then the nominal interest rate should be

r = (1 + O.05)(1 + 0.20) - 1 = 0.20 + 0.05(1 + 0.20) = 0.26 = 26%

2.2 Effect of Inflation on Loan Reeayment

Loan service is composed of Lnterest on the opening princlpal and

repayment of some portion of the principal. The interest ie recorded as expense

ln the income statement whereas the principal repayment reduces the loan value

recorded in the balance sheet. During lnflation, however, this behavior is

changed.

in order to simpllfy the analysis of the effect of inflation on loan

service and on the interest expenses, let us assume that the actual inflation

rate equals the expected rate used in determLnLng the nominal interest rate.

(ThLs assumptlon ie discarded later in section 2.6). Then, the interest expense

on a loan, L, ie

rL - pL + r*[(l + p)Lj

where L - loan's principal at beginning of year.

Given the former example, the lnterest expense on a $100 loan is

rL - 0.20*100 + 0.05((1 + 0.20)*1001 - 20 + 6 - $26

The interest expense is composed of:

1) Inflation-compensation on the principal,

20% on $100 - $20

2) Real (pre-Lnflation) lnterest on the princLpal, restated to year-

end pricees

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5% on $120 - $6

The inflation-compensation of $20, at the end of the year, is equal to the

decline in the purchasing power of the principal - the $100 principal at the

beginning of the year should have appreciated by the end of the year to $120 in

order to maintain its purchasing power, but it remains $100 because $20 has been

repaid by the nominal interest expenses.

In other words, during inflation, the nominal interest expense includes

a fraction which is not a real interest expense but rather a part of the

principal repayment - the inflation-compensation of principal. The inflation-

compensation on the principal should be charged to the balance sheet, but

following conventional accounting procedures, it is charged to the income

statement. The above explains the unique behavior of interest expense during

inflation.

In the case of an index-linked loan, both the real, pre-inflation interest

on the restated loan ($6) and the restatement differential ($20) are recorded

as interest expense in the income statement. But since the restatement

differential of $20 is not paid out, it is recorded as additional liability

through the indexation of the loan (from $100 to $120).

The higher the inflation rate, the larger the fraction of the loan's

principal repayment embodied in the nominal interest expense (pL). Suppose the

inflation rate is 80% instead of 20% in the former example, then the interest

expense is

rL = 0.80*100 + 0.05f(1 + 0.80)*1001 - 80 + 9 - $89

compared to $26 under 20% inflation, or $5 with zero inflation.

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It should be mentioned that in reality the prevailing nominal interest rates are

not necessarily fully inflation-compensated as assumed above, and discussed

below in Section 2.6

2.3 Illustration

The unique effect of interest expense on a company's financial statement

during inflation is illustrated on a simplified example. Consider a firm with

an investment of $200 in land. The investment is financed by $100 equity and

$100 "standing" loan, the principal of which is not repaid, carrying 5% interest

per annum. The earnings before interest are $20, paid at the end of the year.

For simplifying the presentation, it is assumed that there are no inventories

and depreciable assets and no investments, disinvestments and equity issues over

the years. The $15 net income ($20 earnings less $5 interest) is paid out as

dividend at the end of the year, assuming income tax does not exist. These

conditions can prevail perpetually.

Suppose now that inflation started, that is, during the year 19x2 the

general price level increased by 20%. Accordingly, the nominal interest rate

increased to 26%, as explained above. Suppose further that the year-end

dividend is fully inflation-compensated; that is, the dividend is set at the

pre-inflation amount plus 20% inflation-compensation.

The corresponding financial statements - for both 19xl, the pre-inflation

year and 19x2, when inflation prevailed - are presented in Exhibit 1. The

income statement and balance sheet for 19xl represent a steady situation under

a constant price condition. The cash flow in each year - 19xl and 19x2 - is

equal to the figures recorded in the income statement. The income statement for

- is -

l9x2 shows that both the earnings before interest and dividend increased by 20%

from 9xl to 19x2, corresponding to the 20% inflation. But the interest expense

increased by much more, since it includes $20 inflation-compensation of the

principal. As a result, there is a $20 loss (after dividend) which is financed

by an additional loan, as recorded in the conventional balance sheet for

December 19x2. This loss, however, would be eliminated by restating the opening

balance of land (which is stated in current cost) using a 1.2 restatement factor

(Section 4.1). The equity in the restated balance sheet ($120) is derived by

subtracting the debt from the restated assets (240 - 120).

To complete the adjustment of the firm's illustrative financial

statements, the adjusted net income must be derived. Two procedures for

deriving the adjusted net income are presented in Exhibit 2. The corresponding

procedures used in deriving the adjusted net income are discussed in Sections

3.5-3.7, except for the item "Gain on net monetary position" which is explained

below.

2.4 Gain on Net Monetary Position

IAS 29 requires that the gain on net monetary position will be included

in the adjusted net income (par. 26). Net monetary position is defined as

liabilities less monetary assets. Since this amount is stated in nominal money

units (see monetary items; Section 1.6), it is not restated whereas the other

balance-sheet items (nonmonetary assets; Section 1.6) are restated. The meaning

of the gain on net monetary position can best be explained by the following

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diagram; repreenting the opening restated balance sheet.

A Monetary assets CDebt

B Nonmonetary EquLty Dassets

The net monetary positlon io indicated in the dlagram by {B-D}

In the case of the illustrative fLrm, the opening balance sheet in current

prices, Ls;

Debt - $100Land a $200

. EquLty - $100

The net monetary position is 200-100 - $100

The galn on this item is $20 as followsp

Glven 20% lnflation during the year, thle balance sheet should be restated at

the end of the year. The restatement gains are

Land, $200 * 0.2 40

Leass Equity, $100 * 0.2 (20)

Net restatement galn 20

_ 17 -

The net restatement gain should be added to the not income while determining the

adjusted net income, ae recorded in exhibit 2.

Alternatively, the net monetary poition represents the debt whlch

finances the nonmonetary assets. Since the latter is restated but the former

is not, there iu a restatement gain, called gain on net monetary position. In

the llluetrative flrm, the net monetary position, determined by the debt, is

SlOC and the gain is

100 * 0.2 - $20

The $20 gain on net monetary positlon represents the decline ln the real

value of the debt during the year, which is already included in the nominal

interest expense as inflation-compensation of the loan's principal. In other

words, since the inflation-compensation on the principal, which is included in

the interest expense, is charged to income, the restatement gain on this

principal should be credited to income, as shown in Exhibit 2. This is the

reason that according to IAS 29, it may be helpful if the interest expense is

presented together wlth the gain on net monetary posltion (par. 26). This

situation holds when the nonmonetary assets consist only of long-life assets.7

2.5 Deriving the Real Interest Rate

Section 2.1 shows how to determine the nominal interest rate during

inflation, given the long-run, pre-inflation interest rate and the expected

inflation rate. Here, the reverse is shown - how to determine the real,

inflation-free interest rate, given the nominal prevailing interest rate and the

actual inflation rate. Thus, the real, inflation-free interest rate is

determined by

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I + r

1 +p

where r' = real, inflation-free inter4. rate,

r - prevailing nominal interest rate,

p - inflation rate, actual,

Suppose the nominal interest rate is 26% and the actual inflatlon rate was 20%,

then the real interest rate ia

1 + 0.26r - - 1 =0.05 = 5%

1 + 0.20

2.6 The Suppressed Interest Rate Case

The discussion in the former sectLons assumes that the interest on loans

includes a full inflation-compensation on the principal and that the actual

inflation rate was equal to the expected rate used in determining the interest

rate. In real life, however, dLicrepancies between the expected inflation rate

and the actual rate usually exist. Furthermore, in many economies there are

institutional regulations controlling the nominal interest rates, thereby often

suppressing the nominal interest rates. Such a situation is illustrated below.

Suppose the actual nomlnal interest rate was 15% and the inflation rate was 20%,

then the real interest rate is

1 + 0.15…------- -1 = -0.0417 = -4.17%

1 + 0.20

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That is, the actual interest rate was set at such a level that did not even pay

the full inflation-compensation on the principal. The borrower received $100

at the beginning of the year and repaid $115 at the end of the year, despite the

fact that maintaining the purchasing power of the loan requires a repayment of

$120. The $5 difference on the $120 inflation-compensated sum is 4.17%.

3. ILLUSTRATION OF ADJUSTING FINANCIAL STATRNTW1S

The purpose of this chapter is to provide a simplified illustration of the

procedures required for inflation-adjustment of a company's conventional

financial statements. In other words, given that the company did not apply IAS

29, or any other inflation-adjustment procedure, to restate its financial

statements, the illustration should guide the analyst how to derive the resta-ed

(inflation-adjusted) information from the available figures, to arrive at

adjusted statements that suit IAS 29's requirements.

The illustration provides an overview of the inflation-adjustment

procedures. A simplified example serves for illustrating in a stepwise way, the

application of the procedures required to arrive at inflatiun-adjusted financial

statements, including derivation of the adjusted net income.

To simplify the presentation, only the main items of the financial

statements are included in the example. Furthermore, the results of applying

the cumbersome restatement precedures, especially those related to nonm.nnetftry

assets (inventories, investments, fixed assets), in the form of restated

figures, are presented here. These results are based on the procedures for

deriving the restated figures which are presented and illustrated in Chapter 4.

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3.1 The Original Data

The conventional financial statwments, which serve for illustration, are

presented together with the restated statements in Exhibits 3 and 6.

Openina Balance Sheet - The conventional balance sheet of a company for December

31, 1988, is presented in the left column of Exhibit 3 (Opening balance sheet).

The company holds five categories of assets acquired over the past years and

recorded at historical cost; totaling $480. The assets are financed mainly by

liabilities ($350) and partially by capital stock ($50) issued in some given

dates in the past, and retained earnings ($80) accumulated over time.

Closing Balance Sheet - The conventional closing balance sheet for December 31,

1989 is also presented in Exhibit 3. During 1989 the company neither invested

nor disposed of shares or fixed assets, also no equity additions or withdrawals

occurred. Therefore, the recorded nominal value of the shares, land and capital

stock did not change during the year. The recorded value of the depreciable

assets declined only by the nominal depreciation of $20. The retained earnings

increased by $50 as determined by the conventional income statement (Exhibit 6).

income Statement - The conventional income statement for 1989 is presented in

Exhibit 6. All the item in the statement are recorded at historical values -

sales, purchases, expenses and interest Lncurred during the year, whereas the

opening inventory value and depreciation represent cost incurred before 1989.

The net income of $50 is retained, given that the company does not pay income

tax. The company dLetributed $10 dlvidend by several payments during the year

1989.

- 21 -

3.2 Restating the 2ning Balance Shet

The indLvLdual ltems in the conventional openlng balance sheet (December

31, 1988) should be restated to December 1988 priceo. This is the main tlme-

consumLng step when detailed restatement ia carried out; that is, when each

asset is revalued.

Assets - The monetary assets (cash, receivables, investment in bonds, etc.),

whlch are stated in nomlnal money units, do not requlre any restatement, because

the nominal value represents the real value of the asset concerned. Therefore,

the value of these items ln the restated balance sheet equals the recorded value

in the conventional statement (S10O in Exhlbit 3). In contrast, the nonmonetary

assets - inventories, shares, depreciable assets, and land are restated. The

restatement can be carried out in two ways:

1) Applying the corresponding restatement factor (Section 4.1) to each

recorded transaction in these assets over the company's history, or

2) Using approximating factors, applied to groups of assets (not

presented here because of space limitation).

The restatement process of the nonmonetary assets inflated the values of

the four categorles of assets from $380 (80 + 50 + 200 + 50, respective

historical values) to $570 (100 + 70 + 300 + 100, respective restated values).

That ls, the historLcal costs of these assets, restated to December 1988 prices,

is $570 rather than $380 as recorded in the conventional historical-cost balance

sheet.

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To comply with the accounting principle of "the lower of cost or market

value", the market value of the main items was estimated not to be lower than

the restated values.

Equities - The liabilities (payables, received loans, etc.), which are monetary

items and stated in nominal money units, do, not require any restatement as the

nominal value represents the real value of the liability concerned (Section

1.6). Therefore, the restated value equals the recorded value in the

conventional statement ($350 in Exhibit 3). The capital stock, which has been

issued in the past, is restated. The restatement is carried out by applying the

corresponding restatement factor (Section 4.1) to each recorded capital stock

transaction (equity addition) over the company's history. If these data are not

available, the capital stock item should be added to the retained earnings. The

retained earnings item is not restated; it is derived by subtracting the

liabilities and capital stock from the total restated assets (Exhibit 3), that

is,

670 - 350 - 200 = $120

It should be noted that the liabilities compose 52% of the restated balance

sheet (350/670), whereas the corresponding figure derived from the conventional

balance sheet is distorted and accounted for ae much as 73% (350/480).

3.3 Restating Intra-Year Capital Transactions

Intra-year capital transactions are those transactions incurred during the

year which directly affect the level of balance-sheet items, such as investments

or disinvestments in shares, fixed assets, and equity additions or withdrawals.

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Theme transaotions should be estated to year-end prices. The regtatement of

these lteme can be carrLed out ln two ways*

1) Applylng the correspondLng restatement factor (Section 4.1) to each

recorded transactLone or

2) Vaing the average price index (SectLon 4.5) for the restatement factor,

assumLng that the transactions lncurred more-or-less evenly durLng the year.

RestatinQ DLvldend Payments - The treatment of dlvidend payments ix similar in

nature to that of capltal transactions. This ls because the dividend payment

can be viewed sLmilarly to wLthdrawal of equLty. The restated dividend payments

are not added to the restated financLal statements but rather considered

separately.

Illustratlon - To slmpllfy the presentation, the illustrative example assumes

no capital transactLon. To illustrate the restatement procedure, nevertheless,

it is assumed that the company distributed $10 in several dividend payments

during 1989. ThLs sum Ls restated to December 1989 prices, using the average

prlce index. The restatement factor ls

PrLce lndex Dec. 1989…------------------------------------- - .1

Average prlce index Dec. 1988 - Dec. 1989

Thus, the restated divldend payments Ls

10 * 1.1 - $11.

This sum should be added to the adjusted net income in computing the cormnany's

returns for 1989.

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3.4 Restatina the Closing Balance Sheet

The restated closing balance sheet la the result of adjusting data from

three sourceet

1) Monetary assets, inventorles and liabliLties - derlved from the

conventional closing balance shoet. These items are treated

according to the procedures outlined ln Section 3.2

2) Shares, depreclable assets, land, and capltal stock - derlved from

the opening restated balance sheet. These iteme are updated to

year-end prlces (section 4.3).

3) Intra-year transactions related to shares, depreciable assets, land

and equity. These items are restated to year-end prices as outlined

in the former section.

Monetary Assets and Inventories - Monetary assets are not restated, therefore

their value in the restated balance sheet equals the recorded value in the

conventional statement ($110 in Exhibit 3). The restatement process inflated

the value of the closing inventorLes from $100 to $110.

Nondepreciable Assets and Capital Stock - The restated values of shares, land

and capital stock, as recorded ln the opening restated balance sheet (December

31, 1988), are updated to December 1989 prices. Given that there were no

transactions in these ltems durlng 1989 (and no decline in the market values

below the restated values), and that the inflation rate was 20% during the year,

the indlvidual items are inflated by uslng a restatement factor of 1.2 (from $70

shares, $100 land, and $200 capital stock, in December 1988 to $84, $120, and

$240, reapectively, in December 1989.

- 25 -

Depreciable Assets - The treatment of depreciable assets, such as plant and

equipment, involves the restatement of both assets value and depreciation

expenses, to December 1989 prices. Given that there was neither investment nor

disinvestment in these assets during 1989 and that the inflation rate was 20%

during the year, the corresponding restated values are presented in Exhibit 4.

The restated opening acquisition cost of $400 is updated to $480 in

December 1989 prices (restatement factor of 1.2). The $32 depreciation for 1989

is derived from the restated acquisition cost, and stated in December 1989

prices.

3.5 Deriving the Year's Adjusted Net Income

The simplest way to derive the inflation-adjusted (current-cost) net

income of a company is *oy measuring the change in equity between the closing and

opening balance sheets, where the figures are stated in year-end prices. The

adjusted paid-out dividends should be added to the adjusted net income to

adequately evaluate the return on the company's assets and equity.

The adjusted net income for the illustrative company in 1989 is calculated

in Exhibit 5. The value of equity is equal to the restated value of assets less

liabilitiesi that is, $320 Ln December 1988, $442 in December 1989. When these

values are stated in December 1989 prices, the value of equity increased, during

1989, by $58. This sum represents the adjusted net income for 1989. In

comparison, the net income, as reported by the conventional income statement,

is only $S5 (Exhibit 6). Taking into account the adjusted paid-out dividends

of $11, stated in December 1989 prices, the total returns for the year are $69

- 26 -

(50 + 11). Relating these returns to total opening restated assets of $804 (in

December 1989 prices) implies 8.6% return (69/804).

Advantage of the Procedure - The derivation of the adjusted net income from the

restated balance sheets simplifies the computation of the adjusted net income.

Moreover, this procedure avoids mistakes that often occur when the adjusted net

income is derived directly from the adjusted income statement. This is because

of the cumbersomeness of combining income-statement data with restated balance-

sheet data as shown in the next two sections.

Alternative Procedures - There are two ways to adjust income statements:

1) Adjusting only balance-sheet-derived items (inventories and

depreciation) and adding balance-sheet restatement gains, as

presented in Section 3.6 below. (See Goldschmidt and Admon, 1977

and Goldschmidt et al 1986).

2) Restating al income-statement items and adding restatement gains

from both balance sheet and income statement, as presented in

Section 3.7 below. (See Stickler and Hutchins, 1975 and accounting

standard committee 1986)

3.6 Adjusting the Income Statement

The conventional income statement for a given year includes some items

that are recorded at cost incurred in former years, such as inventories and

depreciation. One way to derive an adjusted income statement is to restate

these items and to add the balance-sheet restatement gain (loss), as illustrated

below. This procedure is relatively simple to apply but the adjuated figures

are stated in year-end prices whereas the other income-statement items are

- 27 -

stated in year-average prices, a situation that creates some problems when the

lndlvidual items in the adju.sted lncome statement are used for planning and

control.

The conventional income statement for 1989 and the adjusted statement

following the above mentioned procedures are presented in Exhibit 6. As can be

seen, only the inventories and depreciatlon are adjusted (figures are taken from

Exhibits 3 and 5). Derivatlon of the restatement gains deserves some

explanation.

Balance-Sheet Restatement Gains - Recall, four ltems of the closing balance

sheet (for December 31, 1989) are derived from the opening balance sheet (for

December 31, 1988): shares, depreclable assets, land and equlty. These are

long-life nonmonetary assets and equity. Monetary assets, lnventories and

liabilities, on the other hand, are derived from the closing balance sheet

(Section 3.4).

The opening restated balance sheet for December 31, 1988 is depicted in

Exhibit 7. As can be seen, the $470 long-llfe nonmonetary assets are financed

by $320 equity. As both items are restated to December 1989 prices, but the

value of the non monetary assets exceeds that of equity, there are restatement

gains.8 The derivation of these gaLns is presented in the footnote of Exhibit

6 and ln Exhibit 8. The net restatement gaLns of $30 are added to the net

income to arrlve at the adjusted net income of $58 (Exhlbit 6).

3.7 Restatina All Income-Statement Items

Adjustment of the conventlonal income statement can be carried out by

restating all the ltems to year-end prlces. ThLi procedure provides improved

- 28 -

information for planning and control purposes, but it is more cumbersome to

apply and difficult to comprehend.

The conventional income statement for 1989 and the adjusted statement,

following the above mentioned procedure, are presented in Exhibit 9. As can be

seen, all the items are adjusted to December 1989 prices by applying the

corresponding restatement factor to each item. The derivation of the gain on

net monetary position deserves some explanations.

Gain on Net Monetary Position - The derivation of this gain is more complicated

than the derivation of the net restatement gains, as explained in the former

section. This is because all the income statement items are restated and thus,

the restatement gains on both balance-sheet items and income-statement items

must be calculated. The source of the gain lies in the excess of liabilities

over monetary assets which are not revalued (see Section 2.4). The derivation

of this gain is presented in Exhibit 10. The gain of $40 is added to the net

income to arrive at the adjusted net income of $58 (Exhibit 9).

Overcoming the Cumbersomeness - The fully restated income statement, as

presented in Exhibit 9, provides figures that are stated in year-end prices.

Thus, these figures can be used directly for planning and control purposes, as

required by IAS 29 (par. 25). However, besides this advantage, the derivation

of the figures, especially deriving the gain on net monetary position, is

cumbersome and difficult to comprehend. To overcome this limitation and to

arrive at the figures suitable for planning and control, it is possible to carry

out only two simple computationst

- 29 -

1) DerLving the adjusted net Lncome from the restated balance sheets

(as explained ln Section 3.5), and

2) RestatLng the lndlvldual lnoome-statement ltems to year-end prlces.

3.8 Updatlng Tlme-Serles Restated FLiures

The restatement process of fLnancial data pertalns to the price level of

the year under analyals. The balance-sheet iteme are restated to year-end

pricese most of the Lncome-statement items are recorded ln year-average prices

(Exhiblt 6), or restated to year-end prlces (ExhibLt 9). In order to enable

lnter-year comparLson of the figures, these should be updated (Section 4.3) to

the prlce level at the last date of the serles of figures. Thli procedure is

lllustrated below.

Time-serLes comparison of the restated 1988'. and 1989's balance sheets

for the illustratlve company is presented ln Exhlbit 11. As can be seen, the

real value of four categories of assets decreased from December 31, 1988 to

December 31, 1989. Thus, the total real value of the assets decreased by 6%

(from $804 to $752, ln December 1989 prLces), whereas the real value of the

equity Lncreased by 40% and the level of the liabilltles decreased by 26%.

4 * TOOLS FOR RESTATING FINANCIAL DATA

In order to make the flnancial statements meaningful durlng a period of

lnflatlon the figures, whlch are recorded at historical costs (Lncurred at the

recordlng date), must be restated, uslng an appropriate prlce index. The

purpose of this chapter is to present the maln tools required for these

restatements.

- 30 _

IA8 29 requlres using a general prlce Lndex that reflects changes in the

general purchasing power (par. 35). In most countrLes the Consumer Price Index

iL the approprLate Index. In the case that prLce index is not avaLlable for the

perlods for whlch the restatement of flxed assets li required, an estimate base

should be used, such as the movements ln the exchange rate between the reporting

currency and a relatlve stable forelgn currency (lAB, par. 15).

4.1 Restatement Factor

Restatement factor is used to lnflate a glven value in proportion to the

lnflation that has occurred sance the recording date.

Prlce index at end of analyzed pariodRestatement factor - -------------------… ----

Prlce lndex at recording date

This factor is used for two types of inflation-adjustmentes:

1) RestatLng hLitorical financial figures to current price level, for

analyzing a glven year's financial data, and

2) Updating restated flnanclal figures for Lnter-year comparison of

financial data.

4.2 Restating HistorLcal Fiures

To arrlve at a meanLngful year-end financLal figures, the recorded figures

should be restated. Restatemant means translating figures from historical

dollars, recorded at a given date, to dollars of purchasing power at a later

date, uslng a restatement factor.

Examples A company invested $100 in June 1985 and $200 in July 1988.

The restated value of these investments for December 1989 is $S568:

- 31 -

June 1985 July 1988 Dec. 1989 Total

Price index 130 210 330

330 330 330

Restatement factor -- = 2.54 --- - 1.57 --- = 1.00130 210 330

Recorded cost $100 $200 $300

Restated cost 254 314 568

4.3 Updating Restated Figures

To enable inter-year comparisons of restated financial figures, these

figures must be updated to the last date for which the analysis is carried out.

Updating means translating figures from restated dollars for a given date in the

past to dollars of purchasing power at a later date, using a restatement factor.

Example: Adjusted financial figures for December 31, 1988 and December 31, 1989

are compared, as followst

Dec, 31, 19u8 Dec. 31, 1989 GrowthAbsolute Relative

Price index 220 330

330 330

Restatement factor --- - 1.50 --- = 1.00220 330

Restated figures for every year:Assets $1000 $1650

Net income 110 140

Updated figures: $1500 $1650 $150 1.10

Assets

Net income 165 140 -25 0.85

- 32 -

4 4 Average Price Index

An average price index for a given period should be used for restating

values that are incurred evenly throughout the perlod.

Sum of t indexes for n perlodsAverage prlce lndex - -----------------------------

t

where t - n + 1, which is the number of Lndexes from beginnlng to end of n

perlods.

Thus, the average prlce Lndex for the year 1989 is

Sum of rec. 1988 to Dec. 1989 indexes-------------------------------------

13

Example: ConsLder the following prLce indexes

Oct. 1989 - 3075 Nov. 1989 - 320; Dec. 1989 - 330

The average prlce lndex is

307 + 320 + 330…- … - 319

3

The corresponding restatement factor ls 330/319 - 1.0345

4.5 RestatLag Intra-Year Plows

Intra-year flows lmply fLnancLal transactLons that take place over

consecutive months such as sales and purchases. For accurate results, every

monthly transactions should be restated to the year-end currency. However, when

- 33 -

detailed data are not available or when the flow (in real terms) is uniform over

the analyzed period, the total flow can be restated usLng the average price

index.

Examplet The sales during 1989 amounted to $2000. The average price index for

the period December 1988 - December 1989 was 300 and the price index for

December 1989 was 330. Thus, the restatement factor is

330/300 - 1.1

and the restated sales value in December 1989 prices, is

2000 * 1.1 - $2200

4.6 Holding Time of Inventories

Deriving the average holding time of a stock of Iwventory (that is, the

average age of the stock of inventory, often called turnover time) is required

when the analyst intends to restate the overall value of the stock, rather than

to restate the individual transactLons. Approximating rules are presented below

for two types of inventories:

1) Raw materials, and

2) Goods Ln process and finished goods.

The rules are applicable when the FIFO or the Average accounting methods are

used. 9

Holding Time of Raw Materials - The average time an inventory of raw materials

is held in storage (turnover time), under the FIF0 and Average methods,

express"d in months, is approximated by

Average value of inventory-------------------------- * 12

Cost of materials used

- 34 -

where the average value of inventory is1

Value of openlng + closLng LnventorLes--------------------------------------

2

Examples The financial statements of a company, where the FIFO method Ls used,

record $95 and $105 of materials lnventory in the opening and closlng balance

sheets, respectively; and $400 cost of materlals used. The average time that

the stock is held ln storage is approxLmately

(95 + 105)/2…----------- * 12 a 3 months

400

Holdina Time of Work in Process and Finished Goods - The average time an

inventory of work ln process and fLnLshed goods is held in storage, expressed

in months, is approximated by

Average value of inventory…*---- -- 12

Cost of goods sold

Examples The flnanclal statements of a company, where the FIFO method is used,

record $800 cost of goods sold and

O2enLna B.8. Closing B.8. Average

Goods ln process $120 $120 $120

FLnLihed goods 80 100 90